Category Archives: economics

Inconsistent decision making sometimes leads to a crummy result. Here’s a thought-provoking, quantifiable example from real life.

Two of us were preparing to drive from Boston to New York City. We both wanted to go there, and if we didn’t drive together we would have gone separately. We could take his car, a mid-size sedan that gets so-so mileage, or mine, a compact sedan that gets good mileage.

There’s this system we use to determine who takes on the burden of driving without switching up, without putting a driver in an unfamiliar car. (I have to explain it quickly here with a single paragraph and a table, and then I can give you today’s story.) One person drives the whole way, and the other pays a set rate per mile. Any gas, tolls, or tickets paid have to be covered by that set rate. The payer pays on only half the miles, because if we weren’t doing this complicated auction we’d be splitting costs. This also prevents the suboptimal result that we don’t carpool. The table below shows a 100 mile trip, where Person A will drive. His car will incur costs of $50.

Person B pays A half the costs at $0.60/mi, or $30. Person A’s “hassle premium” is therefore $5 ($5 saved over a 50-50 split of costs, where each pays $25).

Whatever profit may be left over for the driver is compensation for their labor. If the rate doesn’t cover half of the baseline expenses ($gas/mile plus depreciation) then the driver is paying more than half and doing all the work besides. So there’s a floor below which a potential driver shouldn’t bid.

Here’s how it worked last time:

He said, “I’ll drive for half the costs at 80 cents per mile.”

That meant, if I agreed, then he’d do all the driving and I’d pay him 80 cents per mile, times all the miles there and back, divided by two (like the table above).

I generally don’t choose to drive in New York if someone else will do it, but I didn’t want to pay 80 cents per mile to get there. So I said, “78 cents.” (There’s a rule that you can only bid in increments of two cents.) I add, “Remember that your car has GPS in case we get lost.” What I’m doing here is bidding his price down while encouraging him to bid again. He could accept my bid, in which case I’d be stuck with driving. But if he wants GPS, he’ll bid lower.

It works. He wants GPS for the drive, so he says, “76 cents.” I’ve saved myself four cents per mile.

I think the price is still too high, though, so I say, “74. Remember your car also has an audio input, so we can listen to podcasts.”

He says, “72.”

We continue like this for a bit. I’m successful at driving down the price of his driving to 64 cents per mile. Then suddenly I think to myself that maybe driving isn’t so bad, and I could use the lunch money. So I change my mind and the kinds of things I’m saying.

I say, “You know, it’s a bit of a hassle to drive around in the city. Sometimes drivers really cut you off. I’ll drive for 62.” Now I’m sincere.

He sees the change that has come over me and knows that I’m bidding now because I actually want to drive, not because I want to lower the price of his driving. And he knows that my floor is lower than his. In this situation, he can bid us all the way down to his floor and, if I really want to drive, the auction will stop when I bid just below his floor and he accepts.

This is just what happened. It was facilitated by more unhelpful commentary from me, in which I reminded him how awful it would be for him to drive. We settled at my driving for half the costs at 48 cents per mile.

The last time we held an auction to New York, the driver didn’t say anything manipulative to let on his true intentions and got $0.58/mile, over 20% more than what I had just won.

So The Moral Is

Before you enter a negotiation, know what you’re aiming for. And don’t try to game it, because in some circumstances, it just drives your price to the floor.

Imagine that you are the proud manager of the only company that provides food to the people who live in a large area around your plant. Your CFO comes to you for the quarterly update and for the first time in a long time it’s good news. He shows you the graph below:

“We haven’t made money in ten years. If we do nothing, we’ll be on forecast 1, still losing money, but the bleeding is slowing down. We’re going to get through it. We’re lucky that the cost savings and price increases we put in place over the last ten years have set us on that path, because sales and operations are demanding even lower prices and bigger budgets. If we were going to give them what they wanted, we’d be on forecast 2 and still hemorrhaging cash.”

You think about it for a second and ask your CFO, “What does our balance sheet look like?”

He pulls out a copy of the balance sheet and hands it across your desk:

“Oh, hmm, ” you say. “I see our shareholders are in the red by about $15 trillion. God love ’em, they do support us. Let’s give sales and operations what they’re asking for.”

Your CFO should be shocked, but by now he’s totally resigned to your insane management of the company. “Okay,” he says, “I’ll call up our overseas competitors and get additional funds.”

You reassure your CFO, saying, “Don’t worry, they know we’re the only company providing food here. If they need us to pay off the debt, they’ll let us know, and we’ll just raise prices. Our customers will have to pay it. But let’s try to avoid that, okay? Also, call some emergency meetings with sales and operations. Make them work through the holidays to make sure we get onto forecast 2.”

You might think you’d be insane to run a company this way, but oddly enough, this is exactly what we’re doing to ourselves in the United States. See, for instance,